Thank You

Error.

THE VOLATILITY OF THE STOCK MARKET has caused many investors to stash their cash in certificates of deposit, money-market funds -- even under the mattress. There's a better alternative: bonds, some of which offer substantial value, and less agita than equity.

The word's getting out. For the first time in five years, a majority of money managers favor bonds over stocks, reports the quarterly Investment Manager Outlook Survey by Russell Investments. The poll was conducted between Feb. 26 and March 6, just prior to the latest equity rally.

Taxable and tax-exempt bond funds enjoyed net inflows of $36.6 billion last year, versus U.S. equity-fund outflows of $93 billion. Mortgage, investment-grade high-yield and municipal bonds got hammered last year -- regardless of quality -- as the credit markets seized up. But liquidity is improving. Bond prices appear to have stabilized; they're still cheap by historical standards. With the Federal Reserve likely to use all of its firepower to keep interest rates low, less-volatile bonds could well outperform equities this year.

Barron's has picked a half dozen top-notch mutual-fund bond specialists that investors should consider. Their managers share three characteristics: They're conservative, savvy and experienced. Here are their thoughts on where the best values are.

THE CO-MANAGERS of the $2.84 billion First Pacific Advisors' FPA New Income Fund avoided last year's train wreck by changing tracks in 2004 and "05, when they began to worry about mortgage delinquencies. As a result, the managers, Robert Rodriquez and Thomas Atteberry, got rid of Alt-A and subprime-mortgage-related securities. The fund (ticker: FPNIX) also exited high-yield bonds when the possible rewards no longer seemed to merit the risks. Both moves paid off. FPA had a gain of 4.3% last year, beating the typical intermediate-bond fund by 9 percentage points. The fund loaded up on triple-A-rated Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Bank collateralized mortgage obligations, or CMOs, and pass-throughs (pools of mortgages whose cash flows are the monthly payments made by homeowners).

At the end of 2008, the fund had about 36% of its assets in cash, which it has since cut to about 25%, says Atteberry; "it's nice having cash available when someone has to sell" for redemptions. The fund, which has no sector limits or index benchmark, is up 1% year-to-date through April 1.

Right now, about 42% of his mortgages are older CMOs or pools. That's in part because loans written before 2002-'03 were still subject to tougher lending standards and because a five-year-old, 15-year mortgage with a balance of $100,000 or under has a much lower chance of being refinanced, which would leave the mortgage holder stuck with a lower yield.

Atteberry doesn't like Treasuries. "These are unsustainable [low] interest levels, with rates manipulated by the Fed's buying 30-year" debt, he says, referring to the Fed's plan to buy long-term Treasuries. Right now, outstanding Treasury bonds equal 60% of U.S. gross domestic product. By the end of 2010, they'll be 100%. That's about equal to the debt levels in such shaky economies as Italy, Greece and Sri Lanka.

The fund, which can't have more than 25% of its assets rated below double-A, does come with a couple of caveats. Although it has a low expense ratio of 0.61%, FPA has a front load of 3.50%. And Rodriquez, who's never had an annual loss since taking over the fund in 1984, will take a one-year sabbatical next January. However, Atteberry, who's been with FPA since 1997, is a bond veteran who's expected to keep to the same strategy. The two shared Morningstar's fixed-income manager-of-the-year award for 2008.

First Pacific Advisors' Thomas Atteberry: By 2010, the U.S. ratio of debt to gross domestic product will be similar to that of Italy, Greece and Sri Lanka.
Thomas Michael Alleman

Bill Irving, taxable-bond-portfolio manager at Fidelity, concedes it's "very unlikely we'll be able to repeat that performance" this year. He expects the Fed, which plans to buy $300 billion in Treasuries and $1.25 trillion in mortgages, to keep interest rates in a tight range for the year. The $6.92 billion no-load fund was up 0.49% in 2009 through April 1.

Irving doesn't plan to take big chances. He aims to keep 80% of the fund (FGOVX) in government bonds, FDIC-insured debt, government-guaranteed Ginnie Mae CMOs and pass-throughs, and other agency debt. The fund won't buy riskier assets to chase incremental yield. The Government Income fund, which sports a very low 0.45% expense ratio, is designed to provide "steady income, and is a counterweight to the equity component of a diversified portfolio," says Irving. It certainly played that role convincingly in "08.

MUNICIPAL BONDS, generally considered safe bets that rarely default, got whacked last year as fears spread about state and local governments' ability to repay their debts. By autumn, a double-A-rated bond was yielding 6.80%, which was "insanely cheap," says Joe Deane, manager of Legg Mason Partners Managed Municipals Fund (SHMMX).

Deane didn't sidestep all the problems; his $3.9 billion fund lost 9.3% last year. He has, however, returned 3.62% a year on average over the past 10 years, and has already gained 6.97% this year. (Managed Municipals has a front load of 4.25% and an expense ratio of 0.66%.)

Prices got so low early in 2009 in part because hedge funds sold munis to raise cash for redemptions. "We weren't looking for liquidity," says Deane. "We were providing it." Then bargain hunters jumped in, helping to push yields on double-A tax-exempts back down to 5.30% in February.

Legg Mason was able to mitigate losses by buying a lot of pre-refunded munis last year -- refinanced municipal debt that uses its proceeds to buy Treasuries to be held in escrow, from which they pay interest and principal on the original issues.

After the brief rally, yields have begun to creep back up near 6%, a level Deane finds "very cheap." The portfolio manager, who's been with the fund since 1988, recently has been buying essential services' revenue bonds and general-obligation bonds from states and cities "that have the wherewithal and political will" to balance their budgets. Among them: New York City water bonds.

THE MORTGAGE-HEAVYTCW Total Return Bond Fund (TGLMX) posted a 1.1% gain last year. Tiny as it is, that's a remarkable return in light of all the problems in the mortgage-securities market. On an absolute basis, the fund's modest return still placed it ahead of 71% of its intermediate-term rivals, according to Morningstar.

"We have a strong risk-management philosophy," says TCW Chief Investment Officer Jeffrey Gundlach, who oversees the $2.93 billion fund (see related article, "How to Profit from Obamanomics"). The no-load, with an expense ratio of just 0.44%, has tacked on a 2.46% year-to-date return through April 1.

Gundlach has about half his fund in government-backed bonds like Ginnie Maes, Fannie Maes and Freddie Macs, yielding 4%. The other half is invested in nonguaranteed senior mortgage bonds, which carry more risk -- but also an average yield of 18%. "Incrementally, we're finding entry points for triple-A" mortgages because investor fear of delinquencies is very high. A bond originally rated triple-A with 1% to 2% delinquencies, considered "money-good," might fall from par to 90 cents on the dollar, yielding 7.5%. But a mortgage bond with 5% delinquencies drops to 60 cents on the dollar, in part because the credit agencies drop their rating at this trigger to single-B, which is noninvestment grade. Of course, one man's junk is another man's treasure, in Gundlach's view.

Gundlach, with 25 years of managing mortgages for TCW, also was shrewd in targeting the A-tranches of two-part mortgage-backed securities that pay out half of their principal to this A-portion before they start paying principal on the B-slice. The A tranches' losses have been much lower. This is a market where experience counts.

INVESTORS SEEKING a larger playground might consider the $10.4 billion Templeton Global Bond Fund. While the U.S. credit markets froze, this fund (TPINX) gained an impressive 6.3% last year, with investments in sovereign issues from France, Sweden, Korea and Russia, and with a heavy concentration on the credit ladder of single-A, triple-B and double-B-rated bonds.

"Last year is a prime example of the motivation for wanting global exposure," says Michael Hasenstab, portfolio manager. "People have a home-country bias in fixed income," he observes, but a well-run global fund has "lower total volatility." His fund has a five-year trailing-return record of a healthy 7.92%.

The fund consists of three baskets: interest-rate markets, currency markets and sovereign-credit markets -- meaning sovereign bonds not issued in the country's own currency. The fund has a front load of 4.25% and an expense ratio of 0.92%.

Right now, he's short the Singapore dollar because he believes it's vulnerable due to the local economy's heavy reliance on exports and finance. "It will have to devalue to compete," he says. He's also got a big position in the Mexican interest-rate market, where he expects more rate cuts.

The Bottom Line

With the Fed buying billions in Treasuries and mortgage securities, there will be steady downward pressure on rates. Signs of economic recovery will help other market segments.

BARRON'S FINAL BOND-FUND SELECTION is only for the adventurous. It's the T. Rowe Price High-Yield Fund (PRHYX), which dropped a stomach-churning 24.5% last year as the junk-bond market collapsed.

Be aware that corporate defaults are climbing -- and are expected to continue to rise as many credit-challenged companies are unable to refinance their high-yield debt when their bonds mature. This probably won't change until the economy shows signs of reviving. That said, portfolio manager Mark Vaselkiv has loaded up on cheap leveraged loans backed by assets that don't have to return to par to offer a nice return. That's reason enough to give a look.

"Rule No. 1: Don't blow yourself up!" says Vaselkiv, who has run the fund since 1996. The big drag on the market last year was securities issued by private-equity firms for leveraged buyouts. But Vaselkiv is conservative, and has a lot of higher-quality bonds, most rated single- or double-B, in his no-load fund, which has an expense ratio of 0.76%.

In the last big recession, 1991-'93, his annualized three-year total return was 22.3%.

Nearly 50% of the fund is in five sectors: health care, energy, wireless, utilities, and food and tobacco. He's got 10% in investment-grade bonds, and a similar amount in senior bank loans. Just 7% of his fund is invested in highly risky triple-C-rated junk. He also has some convertible bonds. "There's still an opportunity to make double-digit returns the next couple of years," says Vaselkiv. But tread carefully here.